India slows, becomes investment hotspot?

June 28, 2012, 6:42 PM UTC

FORTUNE – This week, Coca-Cola (KO) and Ikea bet billions of dollars on India’s consumers – curiously enough, at a time when growth across one of the world’s fastest-growing economies has markedly slowed.

Over the next several years, Coca-Cola, the world’s biggest soft drink maker, and its local partners will spend $5 billion to expand distribution and add capacity to meet rising demand. This follows a move by Ikea, the world’s largest furniture maker, to enter India with a $1.9 billion investment. It expects to open 25 stores there over the next 15 to 20 years.

Indeed, the commitments will probably take some pressures off of New Delhi policymakers, who’ve been trying to boost faltering foreign investor sentiment, as India’s economy hasn’t been growing as fast as it once did. For the fiscal year ended March 31, GDP grew 6.5%, the slowest pace in almost a decade. Sectors such as manufacturing, mining and agriculture did poorly, raising new concerns about the economy.

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The investments also come as India’s currency, the rupee, has fallen sharply against the U.S. dollar. Consequently, this has frustrated some foreign businesses with units in India, since the money they repatriate in dollars is worth less and that puts a dent on earnings.

But Coke and Ikea aren’t nearly as dismayed. Looking long-term, India’s economy is too hard for the biggest companies to ignore. A few reasons: With 1.2 billion people, India is the world’s second-most populous country; a rapidly growing middle class; and even with slower growth at 6.5%, India’s economy looks far better than much of the developed world as parts of Europe struggles with an ongoing debt crisis and the U.S. economy has grown at an average of about 1.6% over the past 10 years.

More broadly, the latest investments illustrate what’s perhaps a bigger draw: a response to open-market reforms.

Ikea’s entrance into India was made possible by a policy change last year that allows some retailers to own 100% of their Indian businesses. Before, single-brand retailers were allowed to own only 51% of a partnership with an Indian company. The change is significant, since it could open India, one of the last big consumer markets of the world, to many of the biggest retailers that were previously shut out, said Urjit Patel, a nonresident senior fellow at Brookings Institution based in Mumbai.

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Coke is another example. The world’s largest soft drink maker has had a turbulent history in the country. It first began selling its products in India in 1955, but left in 1977 when government regulations changed and required company to have a local partner and hand over its secret ingredients. Coke returned in 1993 after India liberalized its economy, which included changing rules allowing for wholly owned subsidiaries. Since then, the company has been particularly bullish on India, having spent some $2 billion since it returned.

Clearly what will drive India’s growth won’t just be its growing population and rising incomes. India’s bureaucratic government and unpredictable market regulations have been a gamble for many companies. At a visit to
in January, Honeywell CEO Dave Cote said: “I have no math to support this, but I have always felt that just government bureaucracy cost India three GDP points a year. And I am a fan of the country.”

While the number of foreign investments in 2011 rose by 20% to 932 projects over the previous year, the average deal was worth only $63 million – lower than the average $73 million in 2007, according to Ernst & Young.

As more restrictions disappear, more deals will be made.

Ironically enough, if history repeats itself, a flux of market reforms might emerge in the coming years – just as they did two decades ago when India underwent a severe economic slowdown that prompted government officials to push through changes that helped liberalize its economy.